How I’m Positioning For a ‘Santa Claus Rally’

How I’m Positioning For a ‘Santa Claus Rally’

Posted On December 14, 2021 4:11 pm

Stocks are down sharply after getting spooked by a hot Producer Price Index (PPI) report ahead of the Fed’s Open Market Committee meeting — whose policy decisions concerning asset purchases (Quantitative Easing) and interest rates — will be revealed Wednesday afternoon.  The PPI number indicates that inflation isn’t transitory and that prices are increasing at a faster pace.  

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Investors are worried that the Federal Reserve’s behind the curve in fighting inflation, and will now start tightening just as economic growth is slowing. The Fed has maintained an emergency response long after the economic emergency has passed, resulting in the greatest mismatch between its policy and the economy that we’ve ever seen. Basically, the Fed missed a window over the summer to start removing itself from interventionist policies and begin the rates normalization. 

Given the above, it may seem odd that the Options360 Concierge Trading Service  initiated a bullish butterfly in the S&P 500 Index (SPY) yesterday; in anticipation of a “Santa Claus Rally.”  Before I get to the trade and the reasoning behind it, let’s be clear on what we mean by the term.

The “Santa Claus Rally” was coined in 1972 by stock market analyst, Yale Hirsch, who noticed a pattern of higher market returns between the first trading session after Dec. 25 and the first two trading sessions of the new year.  The term has since drifted to encompass a longer time period, covering Thanksgiving to New Year’s. However, strictly speaking, it contains just six trading days. 

The data seemingly supports that, rallies during these time periods, happen more often than not. According to The Stock Trader’s Almanac, the S&P 500 has gained an average of 1.3% during the Santa Claus rally periods since 1950. Since the SPDR’s launch in 1993, the Santa Claus rally has produced gains 18 out of 27 times; roughly two-thirds (67%) of the time.  All other six-day periods, since 1993, have produced positive SPY returns, 58% of the time, with an average gain of just 0.72%. 

There are a number of theories on why this six-day period has delivered statistically-superior returns ranging from people in a good mood during the holidays. Institutional traders are mostly on vacation, allowing retail investors who tend to be stock net buyers, to have a larger impact on people putting their Christmas bonuses into the stock market.  These reasons seem suspect and squishy to me. 

I think the Santa Rally is the result of repositioning. From post-Thanksgiving to late December, money managers are typically engaged in tax-loss selling to help offset capital gains in their winners. This sets up a situation where they start buying and are positioning themselves for the ‘January Effect‘, which is the propensity for stocks to rise during the post-holiday period where stocks sold get repurchased 30-days post-sale to stay compliant with  ‘wash-sale‘ rules set by the IRS for taking capital losses.  

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This year,  the selling has been especially pronounced due to the bear market that’s been occurring under the headline index where many of the high-flying favorites were down some 50%-80% from their highs.  Over the past few days, we have finally seen the mega-caps, such as Microsoft (MSFT), which had been holding up the indices, begin seeing some profit-taking. 

I think this could lead to a similarly-pronounced Santa Claus rally.  As I wrote to my Options360 Concierge Trading Service members in this morning’s Alert; 

Major indices price action has been erratic, with increased volatility and deteriorating breadth. Overall it has not been healthy as even last week’s big bounce was on relatively light volume and looked mostly like short-covering and reactionary from an oversold condition.

That said, the Fed speaks on Wednesday, which could cause a big move in either direction, but there has been a lot of de-risking and a consensus for an accelerated taper with a faster timeline for rate hikes are starting to get baked into the market.

The upshot is, while I’m not really bullish, I think we have to respect this market seems to find a way to regroup and resume a push higher. There is still plenty of liquidity and positive inflows as we head into the seasonally bullish last week (Santa Rally) time of the year.” 

Granted, because I’m not wildly bullish, I’m using a low-cost butterfly spread to put a chip down should the statistical edge offered by the Santa effect play out into the first week of January. 

I can’t provide all the trade specifics because that wouldn’t be fair to my members.  However, I can share the general parameters and the position’s risk profile. 

I’m using the January 7th expiration date which encompasses those first couple days of trading in the New Year.  The width between the strikes is $5 wide with $470 being the middle (body)of the butterfly. The net debit was $100 per 1x2x1 contract spread.  This means my maximum profit is $400; a potential 300% gain, should SPY close at $470 on the 1/07 expiration. 

But, ‘landing’ the maximum profit on the expiration date is an unrealistic expectation.  My target will be to exit for around $2.50 (150% gain), should SPY be in the profit zone a few days early before expiration. 

Be aware, this bullish butterfly play is a low-risk and low-probability trade that can deliver big profits.  If the Santa rally plays out this year, this position will make for a very happy New Year! 

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.